Mortgage backed securities (MBS)

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What are they?

A mortgage backed security is a kind of asset backed security backed by mortgages.

Mortgages are an asset, because anyone who takes one out is committed to paying it off in small chunks over a specified time period. During this time, there is a strong likelihood that the owner of the loan will receive a flow of cash from the person who took the mortgage out. And this flow of cash can be seen as an asset.

In order to form a mortgage backed security, the mortgage loans are typically sold to a specially formed company known as a special purpose entity, which is set up specifically to buy them.

This entity will then usually issue bonds, using the mortgages it owns as collateral.

Investors owning the bonds issued by the SPE receive interest payments. And these interest payments are made using the flow of cash coming from the people who originally took out the mortgages.

What's it got to do with the financial crisis?

In the decade preceding the crunch, the use of mortgage backed securities went through the roof.

In 1990, there were around $1.4 trillion of mortgage backed securities outstanding, according to the US Bond Market Association. By 2001, this had grown to nearly $4 trillion. And by 30 June 2007, this had risen to $6.9 trillion.

It is argued that such huge growth in mortgage backed securities encouraged reckless mortgage lending. Because they knew that they were going to sell the mortgages on to SPEs, the original mortgage lenders were willing to lend to people they would not have lent to had they been forced to keep those mortgages on their own books.

As a result, a higher and higher proportion of mortgages were made to sub-prime borrowers. In 2003, sub-prime mortgages accounted for 9% of the total mortgages taken out in the US. By 2007, this had risen to more than 20% of the market, according to the Center for Responsible Mortgage Lending.

As financial firms try to dig themselves out of the credit crunch, they may be actually jumping deeper into mortgage-backed securities. In the early 1990s, buyers of distressed mortgage-backed securities bought them for pennies on the dollar and often made huge returns on their investment. Hoping for a replay, banks are meddling in mortgages once again, hoping to score enough rich profits to pay big bonuses at the end of the year.

Nor are banks the only ones to fall prey to the lure of mortgages. The US Federal Reserve, seeking to clean up the financial system, has been vacuuming mortgages from banks and may be creating a new credit bubble by being a willing buyer of MBS. Mortgage-backed securities now make up up to 25% of the Fed's own balance sheet and the US central bank has committed to buying $1.25 trillion of troubled MBS backed by government agencies like Fannie Mae and Freddie Mac.

Last updated on 7 September 2009.

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